Page 129 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

Notes

Notes The capital structure depends primarily on number of factors like:

 The nature of industry,
 Gestation period,
 Certainty with which the profit will accrue after the undertaking goes into
commercial production, and
 The likely quantum of return on investment.
However, finance manager should take into consideration following factors while planning the
capital structure:
1. Risk: Risk is of two kinds, i.e. financial risk and business risk. In the context of capital
structure planning, financial risk is relevant. Financial risk also is of two types:

(a) Risk of cash insolvency: As a firm raises more debt, its risk of cash insolvency increases.
This is due to two reasons. Firstly, higher proportion of debt in the capital structure
increases the commitments of the company with regard to fixed charges. This means
that a company stands committed to pay a higher amount of interest irrespective of
the fact whether it has cash or not. Secondly, the possibility that the supplier of funds
may withdraw the funds at any given point of time. Thus, the long-term creditors
may have to be paid back in installments, even if sufficient cash to do so does not
exist. This risk is not there in the case of equity shares.
(b) Risk of variation in the expected earnings available to equity shareholders: In case a firm has
higher debt content in capital structure, the risk of variations in expected earnings
available to equity shareholders will be higher. This is because of trading on equity,
Financial leverage works both ways, i.e.; it enhances the shareholders return by a
high magnitude, or brings it down sharply depending upon whether the return on
investment is higher or lower than the rate of interest.
2. Cost of capital: Cost is an important consideration in capital structure decisions, it is
obvious that a business should be at least capable of earning enough revenue to meet its
cost of capital and finance its growth.
3. Control: Along with cost and risk factors, the control aspect is also important consideration
in planning the capital structure. When a company issues further equity shares, it
automatically dilutes the controlling interest of the present owners. Similarly, preference
shareholders can have voting rights and thereby affect the composition of the Board of
Directors in case dividends on such shares are not paid for two consecutive years. Financial
institutions normally stipulate that they shall have one or more directors on the Board.
Hence, when the management agrees to raise loans from financial institutions, by
implication it agrees to forego a part of its control over the company. It is obvious therefore,
that decisions concerning capital structure are taken after keeping the control factor mind.

4. Trading on Equity: A company may raise funds either by the issue of shares or by
borrowings. Borrowings carry a fixed rate of interest and this interest is payable irrespective
of fact whether there is profit or not. Of course, preference shareholders are also entitled
to a fixed rate of dividend but payment of dividend is subject to the profitability of the
company. In case the Rate Of Return (ROI) on the total capital employed i.e. shareholders
funds plus log term borrowings, is more than the rate of interest on borrowed funds or
rate of dividend on preference shares, it is said that the company is trading on equity. One
of the prime objectives of a finance manager is to maximize both the return on ordinary

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